Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Friday, November 24, 2017

When The IRS Says Loan Repayments Are Taxable Wages

Here is a common-enough
fact pattern:

(1)You have a company.

(2)You loan the company money.

(3)The company has an unprofitable
stretch.

(4)Your accountant tells you to reduce
or stop your paycheck.

(5)You still have bills to pay. The company
pays them for you, reporting them as repayments of your loan.

What could
go wrong?

Let’s look
at the Singer Installations, Inc v
Commissioner case.

Mr. Singer
started Singer Installations in 1981. It was primarily involved with servicing,
repairing and modifying recreational vehicles, although it also sold cabinets
used in the home construction.

After a
rough start, the business started to grow. The company was short of working
capital, so Mr. Singer borrowed personally and relent the money to the company.
All in all, he put in around two-thirds of a million dollars.

PROBLEM:
Forget about the formalities of debt: there was no written note, no interest,
no repayment schedule, nothing. All that existed was a bookkeeping entry.

The business
was growing. Singer had problems, but they were good problems.

Let’s fast-forward
to 2008 and the Great Recession. No one was modifying recreational vehicles,
and construction was drying up. Business went south. Singer had tapped-out his
banks, and he was now borrowing from family.

He lost over
$330 grand in 2010 and 2011 alone. The company stopped paying him a salary. The
company paid approximately $180,000 in personal expenses, which were reported
as loan repayments.

The IRS
disagreed. They said the $180 grand was wages. He was drawing money before and after.
And – anyway – that note did not walk or quack like a real note, so it could
not be a loan repayment. It had to be wages. What else could it be?

Would his
failure to observe the niceties of a loan cost him?

Here is the
Court:

We recognize that Mr. Singer’s
advances have some of the characteristics of equity – the lack of a promissory
note, the lack of a definitive maturity date, and the lack of a repayment
schedule …”

This is
going to end poorly.

… but we do not believe those factors
outweigh the evidence of intent.”

Wait, is he
going to pull this out …?

… because intent of parties to create
[a] loan was overwhelming and outweighed other factors.”

He won …!

However, we cannot find that all of
the advances were loans.”

Then what
would they be?

While we believe that Mr. Singer had
a reasonable expectation of repayment for advances made between 2006 and 2008,
we do not find that a similarly reasonable expectation of repayment existed for
later advances.”

Why not, Sheldon?

After 2008 the only source of capital
was from Mr. Singer’s family and Mr. Singer’s personal credit cards.”

And …?

No reasonable creditor would lend to
petitioner.”

Ouch.

The Court
decided that advances in 2008 and earlier were bona fide loans. Business
fortunes changed drastically, and advances made after 2008 were not loans but instead
were capital contributions.

This “no
reasonable creditor would lend” can be a difficult standard to work with. I
have known multimillionaires who became such because they did not know when to
give up. I remember one who became worth over $30 million – on his third try.

Still, the
Court is not saying to fold the company. It is just saying that – past a
certain point – you have injected capital rather than made a loan. That point
is when an independent third party would refuse to lend money, no matter how
sweet the deal.

Why would
the IRS care?

The
real-world difference is that it is more difficult tax-wise to withdraw capital
from a business than it is to repay a loan. Repay a loan and you – with the
exception of interest – have no tax consequence.

Withdraw
capital – assuming state law even allows it – and the weight of the tax Code
will grind you to dust trying to make it taxable – as a dividend, as a capital
gain, as glitter from the tax fairy.

It was a
mixed win for Singer, but at least he did not have to pay taxes on those phantom
wages.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.